Municipal Deflation: Consequences of the Greatest Speculation

"The financial difficulties of local governments in consequence both of the
inflation and deflation of real estate values demonstrates strikingly the unwisdom
of a revenue system concentrated so heavily upon real estate...."

On March 10, 2010, the Kansas City Missouri School Board voted to close nearly
half its schools (28 of 58). On the same day, Illinois Governor Pat Quinn warned
that if the state income tax is not raised by 1%, education will face "draconian
cuts."

To employ the most hackneyed metaphor of the recent financial meltdown, we
are only in the first inning of municipal deflation in the United States. This
has not gained much attention in the recovery vs. recession debate. Yet, states
and municipalities spend around twice as much money as the federal government.
(Since only the federal government can print money, this comparison may have
changed in the last year.) The gap between tax receipts and spending is forcing
big changes in Missouri and Illinois, though it is probable these cuts are
miniscule in comparison to what is ahead. A recovery is expected in tax receipts
by those who think the economy is rebounding, but in fact the broad swath of
municipalities will suffer deeper reductions in tax receipts for a long time
to come. (Municipalities - cities and towns - receive most of their revenue
from real estate taxes. State revenues are skewed towards income, corporate,
and sales taxes.)

The Great Depression taught this lesson but it was tossed in some ash heap
of history. Revered economists are particularly immune to events that contradict
their theories. In the 1938 Alfred Hitchcock movie, The Lady Vanishes,
the mistaken psychiatrist is told: "You must think of a fresh theory." Doctor
Hartz responds: "It is not necessary. My theory was perfectly good. The facts
were misleading."

Doctor Hartz had a sound reason not to change his theory since reconsideration
may have precluded his intent to murder his victim. In a similar vein, intended
or not, Federal Reserve Governor Frederic Mishkin espoused a murderous theory
that has claimed many victims: "To begin with, the bursting of asset price
bubbles often does not lead to financial instability....There are even stronger
reasons to believe that a bursting of a bubble in house prices is unlikely
to produce financial instability.... In the absence of financial instability,
monetary policy should be effective in countering the effects of a burst bubble." This
prediction was made in January 2007 before the Forecaster's Club of New York.
(Novelists shy from such parody.)

Current theories and books written about the Depression do not dwell on the
1920s real estate boom. Real estate lending in the 1920s might rival the recent
debacle, in form if not degree. There was a flight to the suburbs. The building
balloon included houses, roads, sewers, schools, skyscrapers, and highways
that crossed the country for the first time. When Treasury "Secretary Mellon
endeavored to cut back federal spending, state and local governments stepped
up spending at a rate that more than offset the Mellon program...."

This was speculative building on a grand scale, as Professor Herbert D. Simpson
of Northwestern University informed the Forty-Fifth Annual Meeting of the American
Economic Association in 1933: "Throughout this period there was another form
of real estate speculation, not commonly classified as such, but one that has
had disastrous consequences. This is the real estate 'speculation' carried
on by municipal governments, in the sense of basing approximately 80 per cent
of their revenues upon real estate and then proceeding to erect a structure
of public expenditure and public debt whose security depended largely on a
continuance on the rate of profits and appreciation that had characterized
the period from 1922-29."

In The Crash and Its Aftermath, A History of Securities Markets
in the United States, 1929-1933, Barrie Wigmore wrote: "Municipal governments
were expected to be an active countervailing force in the anticipated business
downturn after the Crash. However, many municipalities were not in a position
financially to bear the twin burdens of unemployment relief and capital construction...." It
is easy to see why. Municipalities were spending because tax receipts rose.
Since tax receipts rose, local governments could leverage growth through
bond issues. Outstanding municipal bond debt doubled in the 1920s. Over the
same period, federal government debt fell by 30%.

With nothing learned, states and municipalities borrowed $23 billion in 2000
and $215 billion in 2007. One reason credit rained on bubbly school committees
was the ever-rising revenue stream from real estate taxes: receipts increased
from $254 billion in 2000 to $421 billion in 2008.

Federal Reserve Governor Frederic Mishkin dismissed the body blows of real-estate
bubbles, but A.M. Hillhouse, author of Municipal Bonds: A Century of Experience,
wrote in 1936: "[T]he major portion of overbonding by municipalities arises
out of real estate booms.... The prize crop of boom bond troubles of all time
came with the collapse of the Florida real estate speculation in 1926." In
consequence, the property tax in West Palm Beach, Florida was raised to 42.5%
of assessed value. This effort to balance the books failed.

At the 1933 meeting of the American Economic Association, Simpson was not
a happy professor: "During this period of prosperity, real estate taxes were
paid with little complaint.... [U]nder these conditions, public expenditures
expanded and taxes were increased without protest.... The result has been a
structure of public expenditure which has been difficult to curtail, and a
volume of indebtedness whose solvency is now jeopardized on a large scale."

Simpson delivered his paper at the bottom of the Depression but the number
of beleaguered municipalities kept rising until 1935, when there were at least
3,252 municipal issues in default. There are at least three reasons to think
current municipal problems will be worse. First, the latest real estate bubble
has probably been much bigger and more leveraged than in the 1920s. Second,
expenses are not as easy to cut. The earlier retrenchment was not hamstrung
by bloated government retiree pension and health benefits. Third, property
assessments lag current prices. This promises to be a fierce battle. Towns
want to hold the status quo so are in no hurry to tax properties at falling
market values; residents do not want to fund comfortable teacher retirements
when they are wondering what happened to their own pension plans.

At the One Hundred Twenty-First Annual Meeting of the American Economic Association
in 2009, Professor Frederic Mishkin (who has departed the Fed and returned
to Columbia University) contributed a paper, "Is Monetary Policy Effective
During Financial Crises?" Whatever he had to say, may it gather dust as the
world learns the lessons taught and discarded by Professor Herbert D. Simpson.

Sheehan serves as an advisor to investment firms and endowments. He is the
former Director of Asset Allocation Services at John Hancock Financial Services
where he set investment policy and asset allocation for institutional pension
plans. For more than a decade, Sheehan wrote the monthly "Market Outlook" and
quarterly "Market Review" for John Hancock clients.

Sheehan earned an MBA from Columbia Business School and a BS from the U.S.
Naval Academy. He is a Chartered Financial Analyst.